Raghuram Rajan must prepare ground for a post-taper world

RBI governors have no option but to master the art of tightrope-walking. Regardless of what diehard inflation-targeters may say, the reality is central bankers have to strike a careful balance between price stability and growth while framing monetary policy.

In that sense, Raghuram Rajan’s position as he contemplates his third bimonthly policy statement tomorrow is no different from US Federal Reserve chairman Janet Yellen’s. But there the similarity ends. Unlike the US Fed that frames monetary policy with its eye on US fundamentals, RBI governors have no such luxury.

Over the last few years, and especially after the 2008 financial crisis, they have had to walk the tightrope with one eye on inflation, another on growth and a third, somewhat wary eye, on the Fed.

A Stitch in Time

So much as Rajan might weigh his options, look at inflation, growth and the government’s fiscal numbers, and gaze skywards to try and figure out if the rain gods will make amends for their late appearance, and then take a call, there is one big imponderable.

By October 2014, when the RBI’s next monetary policy statement is due, the Fed would be buying only $5-billion bonds, down from $85 billion before the taper started in December 2013. So, if the RBI has to safeguard the economy in a post-taper world, it has to prepare the ground now. And that is not going to be easy. More because no one knows what the post-taper world will be like. Interest rates will rise for sure, but no one quite knows when.

Rajan is aware of the pitfalls. In a speech earlier this year, he called for greater central bank coordination, “When monetary policy in large countries is extremely and unconventionally accommodative, capital flows into recipient countries tend to increase local leverage.”

Falling on Yellen Ears

So, “recipient countries are not being irrational when they protest both the initiation of unconventional policy as well as an exit whose pace is driven solely by conditions in the source country”.

However, his plea for greater sensitivity regarding the consequences for emerging market economies like India fell on deaf ears. The US position has been that the Fed is only concerned with domestic interests. Other countries need to put their own house in order before looking to the US to consider the “spillover” effects of its monetary policy. Fair enough.

Except that the US can afford to take this position only because of the dollar’s privilege as the international reserve currency. No one is worried about spillovers from the actions of the central bank of Burkina Faso, which, incidentally, is also the central bank to seven other West African states. Hence Janet Yellen’s cavalier dismissal of the Bank for International Settlements’ warning of asset bubbles building up and leverage reaching danger levels.

Her argument that macroprudential, rather than monetary, policy is the right instrument for financial stability overlooks the reality that macroprudential measures are a poor substitute, especially when taken in isolation. Spain, for instance, had a housing boom despite countercyclical provisioning.

Free market fundamentalists might suggest freely floating exchange rates and liberalisation of financial markets as an answer. But research has shown that countries that undertook textbook policies of financial sector liberalisation often suffer more as deeper markets tend to draw in more flows. It also makes it easier to sell and exit when global conditions turn adverse.

Foundation is the Decider

The IMF’s 2014 Spillover Report warns of turbulent times ahead. Yes, countries with strong fundamentals are likely to weather spillover issues better. Yes, countries that press ahead with structural reforms will be better placed than others. But there, the ball is in the government’s court. The RBI’s mandate and its sphere of influence are much more limited. Indeed, the RBI often has to overcorrect for government excesses. What should the governor do?

RBI executive director Deepak Mohanty’s recent message provides some hints, “Foreign exchange reserves are the first line of defence to contain volatility” in case of capital outflow. Expect the RBI to beef up reserves.

Also, “to the extent capital outflows reflect an imbalance between demand for foreign currency vis-à-vis domestic currency, the price of domestic currency has to go up as a defence against capital outflows”. Expect monetary tightening if flows reverse abruptly, although the bank is likely to keep its powder dry now to deal with any eventuality later. We are in uncharted waters. Rules of macroeconomics have broken down. It is each country for itself. Former RBI governor Bimal Jalan, who steered the country through the East Asian crisis with some rather unconventional monetary policy, put it best.

“The only test of whether correct actions (are) taken or not, is whether policy (is) successful in handling the problem and not whether it conforms to prescribed dictums of international institutions,” he said. That home-grown wisdom has never been more true. Time for Rajan’s third eye to take over.